Last Updated on August 9, 2021
People are emotional beings by nature, and emotions will always adversely affect and influence a trader’s decision-making skills. That is a simple fact. It’s also why it is always crucial to have rigid principles and emotionless strategies when trading. One of the most important rules when trading is implementing a daily loss limit rule. Especially if you are an aggressive trader. Every trader needs to have some sort of loss-limiting system or “rule.” This daily loss limit rule is based on a fixed percentage of total assets or a fixed percentage loss from capital employed in a single trade.
Many trading platforms also have a mandatory daily loss system where a trader’s net loss cannot hit or exceed a predetermined daily loss limit at any point during the trading day. If at any time the loss exceeds the limit amount, the trading platform can potentially flatten any open trading positions, cancel pending orders, or suspend an account from placing any new trades until the start of the next trading day. In most cases exceeding the daily loss limit will also make an account automatically ineligible for a funding program if the trader happens to be in one.
What is a Daily Loss Limit?
A daily loss limit is the maximum amount an investor can lose on their total asset amount or a specific trade per day. Many investors self-implement a daily loss rule, while trading platforms or funding programs create a mandatory loss limit before becoming funded. This daily loss rule is based on a fixed percentage of total assets or a fixed percentage loss from capital used in a single trade.
A good way to think of a daily loss limit is to compare it to a circuit breaker. After a certain percentage (or flat amount) has been lost from a trade, a daily loss limit can automatically stop the trader from trading any longer or immediately exit the losing position. With this daily loss in place, exiting a losing position should be automated and calculated rather than something brought on by a panic attack.
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How a Daily Loss Limit Works in Practice
In practice, the daily loss limit is a way of preserving profits and capping losses. When the limit is reached, disciplined traders simply stop trading without telling themselves that the market will turn around any minute now and risk catching a falling knife. Refusing to follow your own daily loss limit rule is behavior more akin to a gambler than a trader.
Every trader is different, and there is no one right answer for a daily loss limit. It truly depends on your risk tolerance, aggressiveness, and, frankly, emotional stability. A good rule of thumb is to set a 2% daily loss limit for yourself. However, again, it depends on you. Many traders think that a 2% loss limit is too small. For these types of traders, that limit essentially stunts their ability to trade riskier assets that show more volatile behaviors. On the other hand, many professionals and larger-scale investors believe that a 2% loss limit is absurd and too risky. In fact, many of these traders have a 0.5%-0.25% limit in their portfolios. For example, a 2% loss in one of their accounts is considerably higher than a 2% loss for a trader with less capital.
Before even initiating a trade, a daily loss-limit system can be put to work. It’s quite simple, really. When deciding how much of an asset to purchase, you would simultaneously calculate how much loss you could incur on that asset without breaking your daily loss rule. Let’s say you follow the 2% rule, for example. You would also place a stop order within a maximum of 2% loss when establishing your position.
How to Avoid Breaking The Daily Loss Limit
A stop-loss order, first and foremost, is a great tactic to make sure you do not break the daily loss limit.
This order minimizes losses by deciding on a specific price that doesn’t fall below your risk tolerance. If the price of your trade reaches the stop-loss amount, you exit the position. If you do not physically create a stop-loss order, you can also develop a mental stop-loss order and implement it. But if you keep it as only a mental limit, make sure you know yourself and stick to your principles.
There are other things you can do to improve yourself as a trader and limit your losses. First, you can lower your amount per trade. If you lower the amount of money you use per trade, you may cap your gains. However, you will also limit your losses. If you’re always struggling and constantly hitting your loss limits, this will automatically mitigate your risks and put less money on the line.
You should also consider practicing your trading skills on a simulator before trading real money. By trading on a simulator, you can learn what works and what doesn’t work. This lets you correct reckless behavioral patterns when trading. Make sure you analyze everything you do and be your own harshest critic. Make sure you research timing and volatility and also do both fundamental and technical analysis.
Building a trade journal could go a long way in limiting your daily losses as well. Through journaling, you will learn more about yourself and your trading behaviors than you realize. This will force you to review your trades and better understand what is hurting your performance.
Why is This Rule Important?
This rule is important for three major reasons. Reason number one, it creates emotional and psychological clarity when you are trading. Trading can be a very mentally taxing experience. However, if you already know that you will only lose x amount of dollars per day, it makes trading considerably easier, no matter the circumstances.
The second reason is that this is a great way to critique yourself and improve as a trader. Everybody will have an off day. It is a fact of life and a fact of trading. However, if you are consistently hitting your daily loss limit, it could be a sign that you need to improve and learn to read the markets better. Hitting your loss limit frequently signals that you may be doing something wrong rather than the market behaving abnormally. Market crashes like what happened in March 2020 only usually happen once a decade, for example.
The third and final reason is that if you can cap your down days while being profitable on most days, you can quickly move towards a path of more consistent profitability.
Do I Have to Follow This Rule After Getting Funded?
It should not matter whether or not you are funded. Some kind of daily loss rule should be an important component of a well-rounded trading strategy. Whether implementing a stop-loss limit or a strict percentage guideline never to be broken, implementing a daily loss rule instills discipline, risk management, and quality decision-making. Everyone has off days in the markets. Whether you are funded or not, a daily loss rule caps your losses and keeps you stable. Both personally and as a trader.
To ensure you succeed, we also recommend checking out the drawdown in trading and maintain consistency rules.
